Determining Basis in Tax-Free Acquisitions

Mergers and acquisitions are often a significant component of the growth strategies for many companies. CPAs who support these activities can help acquiring companies decide whether to buy the assets of the target corporation or acquire its stock. The latter is generally preferred where feasible, since it can be a tax-deferred transaction under Sec. 368 as long as the basis transfer rules of Sec. 362 are followed. Determining basis of the target corporation’s stock can be a complex and extremely time-consuming operation, but one in which a CPA tax adviser can provide valuable service.

The principal difficulty is that theoretically a basis-transfer reorganization, as in a typical type B or similarly qualifying reorganization, requires compiling the collective bases in the hands of the shareholders of every share of the target company’s stock. It is hard enough to determine who those shareholders are and how many shares they hold, let alone how much they paid for each share. For large public companies, the number of such calculations could run into the millions. Fortunately, the IRS allows the use of methods to aggregate and estimate this information, although even these methods can be demanding for a large acquisition or a target company with a long history of little or no reorganization. And even that guidance has not kept up with practices of stock issuance and transfers—a fact the IRS has acknowledged over the years since its last definitive guidance on such methods 18 years ago in Rev. Proc. 81-70.¹ In 2004, the Service solicited comments on how to bring its estimating methods up to date.² The subject has also appeared perennially on the IRS’s Priority Guidance Plan.

Finally, in late 2008, the IRS issued Notice 2009-4,³ which offers what is still only interim guidance while the IRS develops what it refers to as the “expanded Rev. Proc. 81-70” still to come. In this guidance, the Service provides approaches to determining the basis in the target stock (including safeharbor provisions) that can be employed when it is difficult or reasonably impossible to obtain the necessary tax basis information from the target shareholders. Because more definitive guidance is said to be still at least a year away and Notice 2009-4’s safe-harbor provisions address in some measure the current realities of how stock is transferred and held, practitioners who are knowledgeable and gain experience in helping companies apply these methods can provide a valuable service. An optimally calculated basis in a type B reorganization will save many tax dollars on subsequent taxable transactions.

Type B or Reverse Triangular?

As a general rule in a tax-deferred reorganization, the seller recognizes no gain or loss, and the acquirer takes the same basis as the seller in the property acquired (in other words, a carryover basis). If the acquisition is structured as a stock acquisition, the acquirer simply takes a carryover basis in the acquired stock from the target shareholders.

Sec. 368 provides two alternatives for a stock acquisition: a type B (stock-for-stock) reorganization⁴ or a reverse triangular merger.⁵ (See the exhibit below for a comparison of the two.) The B reorganization is straightforward in its requirements but difficult to accomplish. The consideration provided by the acquirer must be only its voting stock; no cash or other property can be used. The acquirer must also secure at least 80% of the target’s voting stock or the type B reorganization fails and the transaction is taxable. Since the buyer cannot compel the target shareholders to surrender their stock, the results of the transaction often rest squarely on the decision of those shareholders.

The reverse triangular merger is a bit more complicated, but it has important advantages over a type B. To carry out a reverse triangular merger, the acquirer corporation first forms an acquisition subsidiary. The subsidiary merges into the target, with the target corporation surviving. After the merger, the target must continue to hold substantially all the assets it owned before the merger. Of the consideration received by the target shareholders, at least 80% must be the parent corporation’s voting stock. The acquisition is accomplished via state merger statutes and provides more assurance to the acquirer about the impulses of the target shareholders.

One key advantage of a reverse triangular merger is that only 80% of the consideration used in the transaction must be voting stock. This allows the buyer to use up to 20% cash and other property. Recall that in a type B reorganization, the buyer cannot provide any boot consideration. In addition, once the target shareholder approval is obtained (generally a two-thirds majority), the rest of the shareholders are forced to participate in the reorganization. Thus, unlike a type B, the buyer is guaranteed to acquire 100% of the target’s stock. The dissenting target shareholders do not have to accept the parent corporation’s stock but can instead demand cash. The ability to use up to 20% boot is very helpful in a reverse triangular merger and is one reason why this type of reorganization is the more common form in a tax-deferred stock acquisition.

Alternatives for Stock Basis Determination

Determining the basis of the target stock in a type B reorganization is relatively simple in concept. Sec. 362(b) states that the buyer uses the same basis as that of the target shareholders in their target stock. In practice, however, this is difficult if not impossible to do because it requires obtaining the appropriate basis information from all the target shareholders. But in a reverse triangular merger, the acquirer’s basis in the target’s stock is determined by a somewhat more fictional process. According to Regs. Sec. 1.358-6, the transaction is examined as if the target had merged into the acquirer, and the assets and liabilities are then dropped into the acquisition subsidiary.

As a result of this “as if” fiction, the basis the acquirer takes in the target stock equals the sum of the acquirer’s basis in the subsidiary’s stock and the net inside basis of the target’s assets. Net inside basis is the tax basis of the target’s assets reduced by the target’s liabilities. While the results of the transaction are still a stock acquisition, the fiction makes the determination of the target stock basis more easily determined, but perhaps not nearly as advantageous as in a type B reorganization where a higher shareholder basis might be more beneficial.

This determination, however, provides tax advisers an opportunity to help their clients structure a tax-deferred stock acquisition. If the acquisition qualifies as both a type B reorganization and a reverse triangular merger, the regulations will allow the taxpayer to choose either the acquirer’s basis in the subsidiary’s stock plus the net inside asset basis or the carryover basis of the target stock.⁶ It has been the IRS’s long-established position⁷ that if a transaction is structured as a reverse triangular merger but would also meet the requirements of a type B reorganization, the taxpayer is allowed to treat the acquisition as a type B reorganization in determining the transaction’s tax consequences. This ability to choose the tax consequences gives taxpayers flexibility in determining the basis in the acquired target’s stock. The key to obtaining the usually higher and therefore more desirable carryover basis in the target’s stock is ensuring that a reverse triangular merger can also qualify (as it often does) as a type B reorganization in the latter’s strict application of the “no boot” rule.

In most cases, the acquirer’s basis in the subsidiary’s stock plus the net inside basis of the target assets is less than the outside basis of the target stock. With rare recent exceptions, the value of the target has increased over time and its stock has changed hands one or more times. In theory, when this occurs the basis of the stock in the hands of the target shareholders increases each time the stock is sold. This would certainly be the case for a corporation that has increased in value since its inception where the stock is widely held and frequently traded. Based upon this assumption, although it may be a challenge to determine the basis of the target’s stock in the hands of the target shareholders, doing so is necessary so that the practitioner can compare it to inside basis and maximize client results. The IRS has provided the necessary guidance for making these decisions.

IRS Guidelines for Determining Stock Basis

Until recently, the only significant guidance by the IRS for simplifying a basis determination in a B reorganization was a 1981 revenue procedure involving statistical sampling. Then, because of the changing climate of how stocks are held and traded, the IRS believed it necessary to release another notice this year. The cores of these two releases provide the key to a tax adviser’s basis study, and each warrants a closer look.

Rev. Proc. 81-70

In 1981, the IRS identified two significant problems encountered by taxpayers in attempting to establish basis in target stock acquired in a type B reorganization. One was that the acquisition of basis information from shareholders surrendering stock of widely held corporations was time consuming, burdensome, and costly. The other was that not all surrendering shareholders were responding to requests for basis information. To facilitate the determination of basis in these cases, the IRS published Rev. Proc. 81-70,⁸ which set forth general guidelines for surveying target shareholders to determine the basis of target stock acquired in type B reorganizations and provided sampling and estimation procedures to address administrative burdens and shareholder nonresponsiveness.

At the time the revenue procedure was published, most stock was registered (that is, the name of the beneficial owner of the stock was recorded by the issuing corporation’s stock transfer agent on its books). However, market practices have changed substantially since then. Today, stock of public companies is primarily held in street name—that is, the stock is held by a nominee (typically a clearinghouse or other financial institution holding stock on behalf of its members or customers), and the transfer agent’s books list the nominee as the owner of the stock. Often there are several tiers of nominee owners, each subject to confidentiality and other constraints that could bar the release of information. As a result, the identification of the beneficial owners of large portions of public companies, and thus their bases in those interests, is often difficult or impossible to discover.

In addition, the information necessary to identify the nominee holders dissipates fairly quickly. Depositories and clearinghouses (the most reliable means for identifying such holdings) generally maintain securities position reports only for about five to seven years. Thus, unless such information is secured within that time, it will be difficult if not impossible to identify nominee holders if a basis study subsequently becomes necessary.

Notice 2009-4

The IRS has been studying many of the issues raised by nominee stock holdings and as a result recently issued Notice 2009-4,⁹ which states the Service’s intent to issue further guidance for determining stock basis in type B and other basis transfer stock reorganizations. In the meantime, it provides safe harbors under which acquiring taxpayers may estimate the basis of certain shareholders. The notice also requests comments on its contents.

The IRS continues to believe that the theoretically correct method for determining target stock basis following a type B reorganization is a survey of surrendering target shareholders. The IRS also continues to believe that Rev. Proc. 81-70 provides essential guidance for obtaining target stock basis information and for using sampling and estimation techniques in appropriate cases. Thus, those provisions of the revenue procedure will be preserved without material modification in the guidance that the IRS intends to issue.

Notice 2009-4 identifies three safe harbors based on the holder of the stock surrendered. The safe harbor for stock surrendered by or on behalf of reporting shareholders requires the basis of the stock surrendered to be determined by survey. The safe harbor for stock surrendered by or on behalf of registered nonreporting shareholders requires the basis of the stock surrendered to be determined by the certificate method. Under this method, the acquiring corporation must use the books and records of the target corporation to identify the shares surrendered and must use public and private stock exchange data to determine its value. The safe harbor for stock surrendered by nominees on behalf of nonreporting shareholders requires the basis of the stock surrendered to be determined under the basis modeling method. Under the basis modeling method, the value of the surrendered stock is determined by creating a model based on the nominee holdings at certain measuring dates.

Taxpayers can rely on the provisions of the 2009 notice and consider it a safe harbor if the basis study is completed within two years of the date of the reorganization or by January 11, 2011, whichever is later. Therefore, tax advisers may have only a limited window of time to accomplish such an examination using estimation methods under these safe harbors, although the expanded Rev. Proc. 81-70 will also contain safe harbors, according to the IRS.

Once the expanded Rev. Proc. 81-70 is issued, a determination of basis will be considered timely only if it is completed within the later of two years from (1) the date of the type B reorganization or (2) the date the expanded Rev. Proc. 81-70 becomes effective. Any basis studies that have previously been performed can be updated and will be considered to come within the safe-harbor provisions described in the notice if they are accomplished within two years of the date the expanded revenue procedure becomes effective.

It is helpful to understand in very general terms that the IRS requires that a determination of stock basis in a type B reorganization must be done timely and diligently to satisfy the conditions of the notice. For purposes of the expanded Rev. Proc. 81-70, an estimate of basis will be considered to have been done diligently if the acquirer made every reasonable effort to obtain best evidence and, to the extent it was unable to obtain such evidence, can demonstrate that the evidence could not have been reasonably obtained. The fact that the IRS could obtain or has access to basis information using methods not available to the acquirer does not prevent a taxpayer from being considered diligent in its estimate of basis.

What Is at Stake

Initially, the acquiring corporation’s tax basis in the stock of a target corporation acquired in a tax-free reorganization may not have an evident or immediate consequence. For this reason, basis comparisons are often ignored because they are time consuming and costly. However, as recent history suggests, circumstances can rapidly or unexpectedly change in the market, thereby causing the acquiring corporation to dispose of the acquired corporation’s stock in a taxable transaction sooner than anticipated. When such a situation develops, the acquiring corporation’s knowledge of the tax basis in the target corporation is crucial for tax planning because millions or even billions of dollars could be at stake. Tax advisers who are willing to invest sufficient time to study the notice’s safe-harbor provisions and develop an expertise in performing stock basis studies for buyers in a tax-deferred stock acquisition have an opportunity to provide what should be lucrative engagements for their clients.

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EditorNotes

Dave Stewart is the Rachel Martin Professor of Accounting at Brigham Young University in Provo, UT. Steven Thompson is a professor in the McCoy College of Business Administration at Texas State University in San Marcos, TX, and is a former member of The Tax Adviser’s Editorial Advisory Board. For more information about this article, please contact Prof. Thompson at taxman@txstate.edu.

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Notes

¹ Rev. Proc. 81-70, 1981-2 C.B. 729.

² Notice 2004-44, 2004-2 C.B. 32.

³ Notice 2009-4, 2009-2 I.R.B. 251.

⁴ Sec. 368(a)(1)(B).

⁵ Sec. 368(a)(2)(E).

⁶ Regs. Sec. 1.358-6(c)(2)(ii).

⁷ Rev. Rul. 67-448, 1967-2 C.B. 144.

⁸ Rev. Proc. 81-70, 1981-2 C.B. 729.

⁹ Notice 2009-4, 2009-2 I.R.B. 251.